Valuation check - PE vs RoE !

Investment is all about market risk. Investing in stocks require a good analysis of the companies. Mere blindly putting all the money in any company may bring a loss. I incurred huge loss in my starting days, before learning some strategy about company valuation.

Valuation checks are crucial before investing in shares as they help determine a stock's true worth, allowing investors to identify undervalued opportunities and avoid overpaying for assets. It is a critical tool for investors to assess the potential of an investment, avoid costly mistakes, and ultimately achieve their financial goals. But how one should check the valuation?

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Over the years, I have realised one simple trick to avoid overpaying for any company. The Starting Point of Valuation Check begins by simply compairing :

PE and RoE

It is always advisable to compare its PE with its RoE.

Here’s why:

– PE (Price to Earnings) tells you how much you’re paying

– RoE (Return on Equity) tells you how much company is earning on its own money

The basic rule that supports this valuation check is :

If RoE > PE → valuation is reasonable
If RoE < PE → stock may be expensive

Take an example to help understand this check.

– Company A: PE = 12, RoE = 18 → Reasonable

– Company B: PE = 24, RoE = 10 → Risky

This single check has saved me from several value traps. Because profit can be shown, but return on equity is harder to manipulate.

• Price to Earnings :

The Price-to-Earnings (P/E) ratio compares a company's stock price to its earnings per share (EPS), indicating how much investors are willing to pay for each rupee of the company's earnings. A higher P/E ratio generally suggests investors expect higher future earnings growth, while a lower P/E ratio may indicate the opposite or that the stock is undervalued.

• Return on Equity:

The Return on Equity , is a profitability ratio calculated by dividing a company's net income (profit after taxes) by its shareholders' equity, i.e the value of the company owned by its shareholders. A higher ROE generally suggests that a company is more efficient at using shareholder investments to generate profits, while a lower ROE might indicate less efficient use of funds.

In good faith - Peace!!

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